To
what extent may capitalized costs of labor paid or incurred by a qualified taxpayer
for engineering and design services constitute qualified costs for purposes of
California's Manufacturers' Investment Credit (MIC)?

LAW

The
MIC is allowed under Revenue and Taxation Code (Rev. & Tax. Code) §§ 17053.49
(Personal Income Tax (PIT) Law) and 23649 (Bank and Corporation Tax (B&CT)
Law). Regulations for the MIC are at Title 18, California Code of Regulations
(Cal. Code Regs.) §§ 17053.49-0 through 17053.49-11 (PIT) and 23649-0 through
23649-11 (B&CT). The MIC is allowable to qualified taxpayers who pay or incur
qualified costs on or after January 1, 1994, for qualified property that is placed
in service in California.

"Qualified taxpayer"
for purposes of the MIC means any taxpayer that has an operating establishment
properly classified under Division D (Codes 2011 through 3999, inclusive 1)
of the Standard Industrial Classification (SIC) Manual, published by the United
States Office of Management and Budget, 1987 Edition. (Rev. & Tax. Code §§
17053.49(c) and 23649(c); Cal. Code Regs., tit. 18, §§ 17053.49-3(a) and 23649-3(a).)
2

Generally, qualified property
for the MIC is tangible personal property as defined in Internal Revenue Code
(I.R.C.) § 1245(a)(3)(A) for use in an establishment 3
of the qualified taxpayer that is properly classified under Division D of the
SIC Manual and is primarily used in a qualified activity. 4
(Rev. & Tax. Code §§ 17053.49(d) and 23649(d); Cal. Code Regs., tit. 18, §§
17053.49-5 and 23649-5.)

The MIC is equal to six percent
(6%) of all qualified costs. Generally, qualified costs for the MIC are costs
paid or incurred by a qualified taxpayer on or after January 1, 1994, for the
construction, reconstruction, or acquisition of qualified property upon which
California sales or use tax is paid. (Rev. & Tax. Code §§ 17053.49(b)(1)(B)
and 23649(b)(1)(B).) Qualified costs for the MIC are limited to amounts that are
properly chargeable to the capital account of the qualified taxpayer. (Rev. &
Tax. Code §§ 17053.49(b)(1)(C) and 23649(b)(1)(C).)

Capitalized
costs of labor that are "directly allocable to the construction or modification"
of qualified property may also be included as qualified costs for purposes of
the MIC. (Rev. & Tax. Code §§ 17053.49(d)(2) and 23649(d)(2).) Capitalized
direct costs of labor are not required to be costs upon which California sales
or use tax is paid. (Rev. & Tax. Code §§ 17053.49(b)(1)(B) and 23649 (b)(1)(B).)
This is an exception to the general requirement that qualified costs for purposes
of the MIC be amounts upon which California sales or use tax is paid.

For
purposes of the MIC, the term "capitalized labor" means all direct costs
of labor that can be identified or associated with and are properly allocable
to the construction, modification, or installation of specific items of qualified
property. (Cal. Code Regs., tit. 18, §§ 17053.49-2(c) and 23649-2(c).) In determining
whether direct costs of labor are properly allocable to the construction, modification,
or installation of a specific item of qualified property, the qualified taxpayer
is required to use the same method of allocation that is required to be used by
the qualified taxpayer for California income or franchise tax purposes under the
uniform capitalization (UNICAP) allocation rules in U.S. Treasury Regulation (Treas.
Reg.) § 1.263A-1. (Cal. Code Regs., tit. 18, §§ 17053.49-2(c)(3) and 23649-2(c)(3).)

The UNICAP rules contained in I.R.C. § 263A 5
generally address the capitalization of costs associated with real and personal
property produced by the taxpayer for resale and property acquired for resale.
6 For purposes of the MIC only, the UNICAP allocation
rules of I.R.C. § 263A are only used to determine whether capitalized costs of
labor associated with the construction or modification of qualified property for
the MIC are direct costs of labor (as distinguished from indirect costs of labor).
(Cal. Code Regs., tit. 18, §§ 17053.49-2(c) and 23649-2(c).) Accordingly, if costs
of labor would be properly treated as direct costs of labor capitalized to an
item of property produced by the taxpayer or acquired for resale under I.R.C.
§ 263A, then such costs of labor shall be treated as direct costs for purposes
of the MIC.

Treas. Reg. § 1.263A-1(e)(3)
provides examples of indirect costs "that must be capitalized to the extent
they are properly allocable to property produced . . ." Treas. Reg. § 1.263A-1(e)(3)(P)
lists engineering and design costs as an example of indirect costs that are required
to be capitalized. However, this reference is only applicable to design and engineering
costs that are not properly treated as direct costs of labor. Costs paid or incurred
to third-party or independent contractors that would be properly treated as direct
costs capitalized to an item of qualified property produced by the taxpayer or
acquired for resale under I.R.C. § 263A may also be qualified capitalized costs
of labor for purposes of the MIC. (See Treas. Reg. § 1.263A-1(e)(2)(i)(B).)

FACTS
AND ANALYSES

In each of the factual situations below, assume
the following:

The business activities of each taxpayer
are properly assigned to SIC Codes, as published in the SIC Manual, under Division
D, Manufacturing (Codes 2011 through 3999, inclusive), and each taxpayer is a
qualified taxpayer for purposes of the MIC. Each taxpayer is not doing business
in an Enterprise Zone, the Los Angeles Revitalization Zone (LARZ), a Local Area
Military Base Recovery Area (LAMBRA) or a Program Area. Unless otherwise specified,
all property discussed is qualified property for the MIC. Except for engineering
and design capitalized costs of labor, assume that all other costs discussed herein
are qualified costs for the MIC and that no election is made to currently expense
any portion of such costs under Rev. & Tax. Code §§ 17265 or 17266 (I.R.C.
§ 179) or any other similar provision, such as the accelerated expensing provisions
provided to taxpayers doing business in an economic incentive zone. 7
For purposes of the MIC, each taxpayer uses the same method of allocation for
purposes of determining whether costs of labor would be properly treated as direct
costs capitalized to an item of property under I.R.C. § 263A as for California
franchise and income tax depreciation purposes.

SITUATION
1

Facts

X Fuels, Inc. (X), is an
integrated oil and gas company that refines petroleum products at its refining
plant in the town of Bedrock, California. Among its various refined products,
X produces reformulated and oxygenated gasoline that complies with the federal
Clean Air Act and meets the standards established by the California Air Resources
Board. In order to comply with these federal and state mandates, X is required
to construct a new "coker", which is a specific item of refining equipment
which will perform one of many steps in the petroleum refining process, at its
refinery in Bedrock. The new coker is self-constructed by X. Only X's employees
are engaged in the actual construction process. X directly purchases all of the
materials necessary to complete the job. However, after January 1, 1994, X enters
into a contract with an independent third-party contractor, Y, Inc. (Y), for certain
engineering and design services necessary for the construction of the new coker.

Under
the terms of the contract between X and Y, the new coker is the only item of property
for which Y is to provide design and engineering services. All of X's payments
under the contract to Y are properly capitalized to the cost basis of the new
coker for federal and state tax depreciation purposes. For purposes of the MIC,
X uses the same method of allocation for purposes of determining whether costs
of labor would be properly treated as direct costs of labor capitalized to an
item of property under I.R.C. § 263A as X uses for California franchise and income
tax depreciation purposes. 8

Analysis

In
Situation 1, the issue is whether the third party contract costs paid to Y for
engineering and design services related to the new coker would be properly treated
as direct costs of labor capitalized to an item of property under I.R.C. § 263A.
As discussed above, the UNICAP rules contained in I.R.C. § 263A are generally
applicable to self-constructed property and property acquired for resale. They
generally do not address the type of property that is qualified property for the
MIC. However, for definitional purposes only, the MIC regulations mandate that
the UNICAP rules be used to determine whether costs of labor are "direct"
or "indirect." Only capitalized direct costs of labor may be qualified
costs for purposes of the MIC. The test for whether costs of labor are direct
costs of labor under I.R.C. § 263A is whether these costs "can be identified
or associated with particular units or groups of units of specified property."
(Treas. Reg. § 1.263A-1 (e)(2)(B); Cal. Code Regs., tit. 18, §§ 17053.49-2(c)
and 23649-2(c).) The engineering and design costs represented by X's payments
to the independent third party contractor, Y, would be properly treated as direct
costs of labor capitalized to an item of property pursuant to I.R.C. § 263A under
Xs normal method of accounting because they are identified and associated
with the new coker.

Holding

In Situation
1, X may include the engineering and design costs represented by Xs payments
to the third party contractor, Y, as qualified capitalized costs of labor for
the MIC because they would be properly treated as direct costs of labor capitalized
to an item of property pursuant to I.R.C. § 263A under Xs normal method
of accounting.

SITUATION 2

Facts

Assume
the same facts as those in Situation 1, except that instead of utilizing the services
of Y for engineering and design of the new coker, X utilizes the services of X's
own employees for this work. Further assume that X has an "Engineering and
Design Department" in which X employs five engineers to accomplish various
engineering and design tasks on an as-needed basis. All five of these engineers
jointly undertake the engineering and design of the new coker in addition to providing
engineering and design for the construction of other items of X's property. X
does not keep separate records of the time spent by each of these employees performing
engineering and design services for the new coker.

Analysis

In
Situation 2, the issue is whether the regular wages and overtime paid to Xs
five engineers for performing engineering and design services for the new coker
would be properly treated as direct costs of labor capitalized to an item of property
under I.R.C. § 263A. The regular wages and overtime paid to X's five engineers
would not be properly treated as direct costs of labor because they cannot be
identified or associated with a specific item of X's property. Pursuant to I.R.C.
§ 263A, the absence of records which show that costs (or some portion of such
costs) are identified and associated with the new coker requires such costs to
be properly treated as indirect costs. Such indirect costs are not qualified capitalized
costs of labor for the MIC.

For purposes of the MIC, to
the extent that the regular wages and overtime paid to X's five engineers would
be properly treated as indirect costs required to be capitalized under I.R.C.
§ 263A, these costs would be allocated among all of the items of property for
which X's engineers provided engineering and design services pursuant to the methods
for allocation of such costs under I.R.C. § 263A. Therefore, for purposes of the
MIC, these costs would be properly treated as indirect costs of labor required
to be capitalized to an item of property under I.R.C. § 263A.
9

Holding

In Situation 2, X
may not include the regular wages and overtime pay for X's five engineers as qualified
capitalized costs of labor for the MIC because they would not be properly treated
as direct costs of labor required to be capitalized to an item of property pursuant
to I.R.C. § 263A under Xs normal method of accounting.

SITUATION
3

Facts

Assume the same facts as
those in Situation 2, except that X maintains separate records on the number of
hours that each of its five engineers spends engineering and designing the new
coker. For example, employee Z spends fifty hours working solely on designing
the new coker and X keeps a written record of this time. Based upon these separate
records, X calculates the amount of each engineers wages and overtime to
be capitalized to the new coker for California depreciation purposes and is consistent
with the accounting method X uses for inventory purposes.

Analysis

In
Situation 3, the issue is whether the regular wages and overtime paid to Xs
five engineers, for which X maintains separate records, for the engineering and
design of the new coker would be properly treated as direct costs of labor capitalized
to an item of property under I.R.C. §263A. To the extent that these costs of labor
are evidenced by separate records, they can be identified and associated with
the new coker. The regular wages and overtime paid to X's five engineers for engineering
and design of the new coker, for which X maintains separate records, would be
properly treated as direct costs of labor capitalized to an item of property under
I.R.C. § 263A.

Holding

In Situation
3, for purposes of the MIC, X may include as qualified capitalized costs of labor
the regular wages and overtime paid to X's five engineers related to the new coker,
for which X maintains separate records, because these costs would be properly
treated as direct costs of labor capitalized to an item of property pursuant to
I.R.C. § 263A under Xs normal method of accounting.

2. The determination of
whether a taxpayer is engaged in an activity that is described in Division D of
the SIC Manual shall be made under the rules and methods described in the SIC
Manual and the MIC regulations on the basis of all of the facts and circumstances.
For purposes of the MIC, a SIC Code assignment to a given taxpayer's activity
made by any federal, state (other than the Franchise Tax Board), regional, or
local government agency shall not be controlling. (Cal. Code Regs., tit. 18, §§
17053.49-3(a) and 23649-3(a).) Back to document

3.
According to the SIC Manual, there are two types of establishments - operating
and auxiliary. For purposes of determining whether property is for use in a Division
D manufacturing activity, the property must be for use in an operating establishment
that is properly assigned a Division D SIC Code or an auxiliary establishment
which is assigned the same Division D SIC Code as the operating establishment
it supports, regardless of the primary activity being conducted in such an auxiliary
establishment. Back to document

4.
Qualified activities for MIC property are specified in Rev. & Tax. Code §§
17053.49(d)(1)(A) through (E) and 23649(d)(1)(A) through (E) and are further defined
in Cal. Code Regs., tit. 18, §§ 17053.49-2 and 23649-2. Back
to document

5. All references in this
Legal Ruling to I.R.C. § 263A incorporate by reference the regulations thereunder.
Discussion or application in this Legal Ruling of federal or state statutes or
regulations dealing with capitalization of property is only for purposes of defining
direct costs of labor for the MIC. Back to document

6.
For the general scope of I.R.C. § 263A, see Treas. Reg. § 1.263A-1(a)(3). Back
to document

7. Unlike under the Personal
Income Tax Law, for most Bank and Corporation Tax purposes, California does not
conform to I.R.C. § 179. However, I.R.C. 179-type deductions are generally available
to corporations doing business in a geographic-based economic incentive zone,
such as an enterprise zone (Rev. & Tax. Code § 24356.2), the LARZ (Rev. &
Tax. Code § 24356.4), or LAMBRA (Rev. & Tax. Code § 24356.8). Under these
provisions, a qualified taxpayer may generally elect to treat the cost of such
property (subject to specified limitations) as an expense that is not chargeable
to capital account. Back to document

8.
For purposes of this Legal Ruling, assume that X must capitalize the coker under
the general authority of I.R.C. § 263. (Comm. v. Idaho Power Co. (1974) 418 US
1 (94 S.Ct. 2757).) Back to document

9.
For the methods of allocating indirect costs of labor that are required to be
capitalized, see Treas. Reg. §§ 1.263A-1(c), 1.263A-2(b), 1.263A-3(d) and related
sections. Generally, indirect costs are allocated using either a specific identification
method, a standard cost method, a burden rate method, or any other reasonable
allocation method (as defined under the principles of Treas. Reg. § 1.263A-1(f)(4)).
(Treas. Reg. § 1.263A-1 Back to document